Wednesday, August 20, 2008

GSE Bailout: It's not impossible

I had previously argued that the GSEs should be broken up into 10 or so separate private companies. On Monday, Alan Greenspan spoke favorably of the same idea. Yesterday, Richmond Fed President Jeffery Lacker argued that the GSEs needed to be nationalized, then "demonstrably privatized" by selling off the remains, likely into more than just 2 pieces.

Such a plan is probably the least risky to tax payers. It also would result in a cleaner and more permanent solution than some kind of Treasury-backed equity investment.

How might this work?

First we'd need to make the GSEs sellable, which they currently are not, as evidenced by their share price. To do this, there would need to be meaningful deleveraging, which has to come at tax-payer risk, I'm afraid. I think the solution is to use GNMA program. Treasury announces they are tendering some amount of Fannie/Freddie MBS. The bonds tendered would be exchanged for GNMA bonds of the same coupon. This would ultimately be similar to the MEGA program. It could be stipulated that all tendered loans would have to meet standard FHA guidelines, so like most hybrid-ARM securities wouldn't qualify. But so what? We'd get the leverage of the GSEs down by a certain degree.

Note that the tender would be initially profitable for the Treasury, because of the spread between GNMA securities and FNMA/FHLMC MBS, currently just under 1 point on 6% MBS, and 2 points on 5.5% MBS. Say GNMA offered to tender any eligible FNMA/FHLMC MBS for 1.5% of the principal balance. GNMA could tender say 10% of the total FNMA/FHLMC balance (about $4.3 trillion) and collect $6.5 billion up front.

The Treasury then fully guarantees the principal of all outstanding Fannie Mae and Freddie Mac senior securities. More on this in a moment. The Fed also extends access to the discount window for some extended period of time, like 3-years or so, to the new owners of the former GSE businesses.

Finally, all current mortgage guarantees would be owned pro-rata by the new companies. So if we created 10 new "GSEs" they would each be responsible for 1/10th of any losses that arose. In this way, the old agency MBS securities would still trade generically, as opposed to being passed off to a new guarantor.

So here is what the buyers of the GSE's broken pieces would get:

  1. Relatively certain liquidity from the discount window
  2. Reduced balance sheet due to the GNMA tender
  3. Pro-rata ownership of the GSE's tax loss carry forwards
  4. Freedom from the GSE's old "public" mission of providing affordable housing
  5. Freedom to price their guarantee however they wish
  6. Freedom to participate in any segment of the mortgage market, not just "conforming" mortgages

In exchange, the buyer has to put enough capital into the new company to realize bank-type leverage levels. Exactly what those leverage levels should be is up for debate, but it should be enough to engender some degree of market confidence.

The market as a whole would get...

  1. More capital put into the GSEs (viewed in aggregate) provided by private investors, which is all but impossible now.
  2. A limit on tax payer's costs. GNMA would collect a profit on the initial tender of MBS, which would offset losses taken in those pools. Plus the government would get cash from the buyers of the GSE pieces. All this would serve to mitigate losses significantly.
  3. A long-term solution to the GSE problem. If there are 10 new entities, none would be too big to fail. All would have to maintain bank-like capital levels, rendering the system safer.
  4. Certainty as to the end game with Fannie and Freddie.

As for common shareholders, they become victims of the GSEs declining capital base. Preferred shareholders and sub debt holders would see their interests split among the new firms. But that would surely result in an increase in the valuation from current levels.

Today both Fannie Mae and Freddie Mac management are meeting with Treasury officials. My take is that Treasury is setting a deadline for them to raise new capital before the Treasury acts. I hope they at least consider something along the lines of what I've proposed here.


Not said...
This comment has been removed by a blog administrator.
PNL4LYFE said...

I don't understand how the current outstanding MBS would or would not be guaranteed. If each of the new entities is responsible for guaranteeing a pro rata share, what happens if one of the 10 new entities fails? Do MBS holders suffer losses on 10%? Or are the other 9 responsible for making them whole? I don't see how you can get around a federal guarantee of all the MBS as well as the senior debt.

I also don't think it would prevent a similar problem from happening in the future. It's reasonable to assume that all 10 companies would operate in roughly the same way. If one management took a more conservative approach than the others, they would lose market share, make less money, and be ousted by shareholders. There will be constant pressure to increase leverage just as there was under the old system.

In my view, the only potential benefit could be that these companies would have risk based borrowing costs which would keep spreads and mortgage rates higher. But that would only happen if people truly believe that the federal backstop is gone. Why would they believe that? In any future crisis, it's not as though one of these entities will fail while all the rest survive; they will all be in the same boat together just as FNM and FRE are now.

Not said...

AI: if you can't handle any criticism of your ideas, you shouldnt have a public blog.

You only want compliments. When your trades don't work, you want to be bailed out.

Accrued Interest said...


You wrote a long diatribe about bailing out common shareholders, which is clearly not what the post is about. I don't want to distract the discussion away from what I actually wrote. Long-time readers know I allow all kinds of criticism as long as its germane. Your comment was not.

Accrued Interest said...


If I own a MBS pool which suffers 5% losses, and one of the 10 is out of the picture, I'd sugger 0.5% of loss. That's how I imagined it.

As far as preventing it from happening again, you can't. But without the implicit government guaranty, there wouldn't be the ability to lever to the degree FNM and FRE did.

Anyway, part of my thinking would be to marginalize this business.

Not said...

AI: the quality of your blog has plummeted since you disabled anonymous comments... at least half the value came from commenters debating ideas back and forth, especially when the conversation moved beyond your initial post.

Now you block anything you don't agree with, as well as arbitrarily deleting some (but not all) comments that go slightly off topic

rbn3 said...

"Fairness" has become a buzzword again of late along with its antonyms "moral hazard" and "bailout". Splitting an entity that is too large to fail into parts only invites the question of setting the "scream" threshold for a sum of parts, as pnl4lyfe said. It would be as George Bernard Shaw put it: "They put you in a tub of water and slowly heat it up. You never know when to scream."

Every small town business man knows that he cannot guarantee success, but he can surely avoid failure if he owes everyone in town money.

Greg said...


If you wipe out current share holders now, how do you get new shareholders to invest in the new companies? What stops the govt from doing it again (and again)?

The current downward hype is as bad as the frenzy which caused the initial housing bubble. The govt should focus on restoring confidence. Complete privatization can only occur after FNM and FRE are healthy again.

The only people that will benefit from the GSEs failing now are hedge funds which will purchase assets on the cheap at taxpayer expense.

Josh Kalish said...

The bonds tendered would be exchanged for GNMA bonds of the same coupon.

If you tendered your FRE/FNM bonds, would you get a newly created GNMA bond? Or is this from the existing Fed inventory?

PNL4LYFE said...

Greg: The gov't can talk all they want, but at the end of the day, the market is telling us that it believes the common is worthless. It's trading at a few dollars because there is still some option value in the event that a bailout somehow saves some value for shareholders.

FNM and FRE "failing" here probably won't change their business in the immediate future. They will continue to buy mortgages and issue debt and MBS guaranteed by the federal government; unfortunately, this is what the housing market and economy need to prevent the downturn from becoming even worse. The restructuring should wipeout shareholders which is exactly what they deserve. If the companies are restructured and sold off in the future, presumably it will be at a price that reflects the market's assessment of it's true value. It won't be given away like a Russian oil company.

PNL4LYFE said...

Slightly off topic question: What will agency spreads do in this scenario? Depending on the structure of the bailout, could they go to nearly zero? It seems like short agency spreads or swap spreads is a good trade here. If agency spreads widen much from here, the government's hand will be force because FNM/FRE can't operate without low funding costs. Obviously this was a much better trade a week ago, but it still seems good here.

Independently, what about short 10y T or bonds here? Seems like a bailout would remove some of the flight to quality bid and create technical pressure as people rotate from Ts to agencies. Not to mention the huge increase in federal liabilities.

Accrued Interest said...

Greg: I think you can get new shareholders because the FNM/FRE business model, with some modifications, is a profitable one. Someone will want to own it.

Besides, there aren't a lot of ways to retain value for shareholders while protecting tax payers. All the profits have to flow to tax payers. So even if you didn't care about moral hazard, it would be hard to pull off.

PNL: It depends on exactly how it plays out. Let's say the Treasury "buys" a $20 billion preferred in FNM and FRE (each) but no explicit backing of the senior. I'd say we tighten to 20bps or so, with a very steep credit curve. Longer stuff would trade weaker on the theory that eventually the government would dispose of the GSEs one way or the other.

Accrued Interest said...


Yes I'd imagine the investor would get a GNMA bond in return.